<4.8 INFLATION & DEFLATION>  

• INFLATION refers to a PERSISTENT INCREASE in the GENERAL PRICE LEVEL over a period of time

• DEFLATION refers to a PERSISTENT DECREASE in the GENERAL PRICE LEVEL over a period of time

• CONSUMERS' PURCHASING POWER FALLS - The purchasing power of consumers goes down when there is inflation - there is a fall in their real income because money is worth less than before.

• CREATES TIME ('SHOE-LEATHER') COSTS for CONSUMERS - Inflation causes fluctuations in price levels, so customers spend more time searching for the best deals. This might be done by physically visiting different firms to find the cheapest supplier or searching online. Shoe leather costs represent an opportunity cost for customers.

• CREATES EXTRA ('MENU') COSTS FOR FIRMS - Inflation impacts the prices charged by firms. Catalogs, price lists, and menus have to be updated regularly and this is costly to businesses. Of course, workers also have to be paid for the time they take to reprice goods and services.

• INVESTMENT UNCERTAINTY - Inflation also causes business uncertainty. The combination of uncertainty and the lower expected real rates of return on investment (due to higher costs of production) leads to lower the amount of planned investment in the economy.

FIXED INCOME EARNERS LOSE OUT - During periods of inflation, fixed income earners (such as pensioners and salaried workers whose pay doesn't change with their level of output) see a fall in their real income. Thus, they are worse off than before as the purchasing power of their fixed income declines with higher prices. Even if employees receive a pay rise, the rate of inflation reduces its real value. For example, if workers get a 4 percent pay rise but inflation is 3 percent, then the real pay increase is only I percent.

EMPLOYERS WILL FACE HIGHER WAGE DEMANDS - Workers are likely to demand a pay rise during times of inflation in order to maintain their level of real income. As a result, labour costs of production rise and, other things being equal, profits margins fall. Those in highly skilled professions such as surgeons, doctors, pilots and barristers are in a strong bargaining position because their skills are in short supply and high demand. This can create a wage-price spiral whereby demand for higher wages to keep in line with inflation simply causes more inflation. Inflation also harms employers located in expensive areas. 

EXPORTERS ARE LOSERS as the international competitiveness of a country tends to fall when there is domestic inflation. In the long run, higher prices make exporters less price competitive, thus causing a drop in profits. This leads to a fall in export earnings, lower economic growth and higher unemployment.

USERS OF ESSENTIAL IMPORTS- If supply-side issues of essential imports such as petroleum and food products cause prices to rise then domestic costs of production will rise causing domestic inflation. Hence, inflation can cause problems for countries without many natural resources.

As deflation usually occurs due to a fall in aggregate demand in the economy, this causes a fall in the demand for labour - that is, deflation causes job losses in the economy.

During periods of deflation, consumers spend less so firms tend to have lower sales revenues and profits. This makes it more difficult for firms to repay their costs and liabilities (money owed to others, such as outstanding loans and mortgages). Thus, deflation can cause a large number of bankruptcies in the economy.

As the profits of firms fall, the value of their shares also falls during times of deflation. This means that dividends and the capital returns on holding shares fall, thus reducing the wealth of shareholders.

The real cost of debts (borrowing) increases when there is deflation. This is because real interest rates rise when the price level falls. For example, if interest rates average 1.0% but the inflation rate is -1.5%, then the real interest rate has risen to 2.5%, this is because the purchasing power of the repayments has now risen. Thus, with deflation and the subsequent rising real value of debts, both consumer and business confidence levels fall, further adding to the economic problems in the country.

With more bankruptcies, unemployment and lower levels of economic activity, tax revenues fall while the amount of government spending rises (due to the economic decline associated with malign inflation). This creates a budget deficit for the government, meaning that it needs to borrow money even though the real cost of borrowing rises with deflation.

Deflation usually causes a fall in consumer confidence levels, as consumers fear that things will get worse for the economy. Thus, they may postpone their spending, especially on consumer durable goods such as cars and furniture, as they expect prices to fall even further in the future or wait until the economy improves. This clearly does not help the economy to recover, thereby causing a downward deflationary spiral.

• IF DEMAND PULL INFLATION then policies to DECREASE DEMAND are used, causing the AD curve to SHIFT TO THE LEFT.

• CONTRACTIONARY MONETARY POLICY: RAISING THE INTEREST RATE, so people save more instead of spending lowering consumption spending (C). The higher rates will discourage businesses (I) and households from borrowing money to spend on goods & services, hence lowering demand and the price level.

• CONTRACTIONARY FISCAL POLICY: Lowering government spending (G) and raising taxes, will reduce the disposable income that households and businesses have to spend, hence lowering demand and the price level

• IF COST PULL INFLATION then policies aim to increase the productivity of the economy causing the AS curve to SHIFT TO THE RIGHT leading to lower prices in the future.

• IF IN A RECESSION/DEFLATIONARY SPIRAL then policies to INCREASE DEMAND are used, causing the AD curve to SHIFT TO THE RIGHT.

• EXPANSIONARY MONETARY POLICY: LOWERING THE INTEREST RATE, so households and firms save less and spend more. The lower rates will also encourage businesses and households to borrow more money to spend on goods & services, hence increasing demand and the price level.

• EXPANSIONARY FISCAL POLICY: Raising government spending and lowering taxes, will increase the disposable income that households and businesses have to spend, hence increasing demand and the price level